As inflation continues to exert pressure on maintenance and operational expenses for those managing residential property, it has become harder to budget for yearly service charge expenditure without the need for end of year balancing charges to make up the shortfall.

This Legal Update looks at common considerations when dealing with such balancing charges.

When do balancing charges arise? 

Balancing charges arise where service charges are collected by way of interim, on account demands. In those instances, the landlord, RTM company or RMC will, at or prior to the start of the financial year, prepare an estimate of how much each leaseholder has to pay as a variable services charge for their block or estate based on their share of contribution towards expected expenditure. If the landlord, RTM company or RMC underestimates and/or there is unexpected expenditure in the year which exceeds the sums demanded by way of interim demands, a balancing charge will be due reflecting the leaseholder’s share of actual expenditure for the year as calculated in the year-end accounts.

The lease will prescribe how the annual accounts must be prepared and the information to be contained in those accounts including, for example, whether there is any requirement for the accounts to be certified or audited.

Where expenditure is not in line with the initial estimate, it is good practice to make leaseholders aware of this as soon as practicable before or after that expenditure, although there is no requirement to do so until the year-end accounts are prepared and balancing demands issued.

If the actual expenditure for the year is less than the sums estimated and demanded by way of interim demands and there is a surplus at the end of the year, a credit will be due back to the leaseholders. Again, the terms of the lease will provide whether that credit is to be paid back to leaseholders, credited to their accounts towards future years’ expenditure, or transferred to a reserve fund.

In some instances it is possible to raise funds for additional or unexpected expenditure in-year, by the issue of ad hoc demands (also known as ‘cash calls’ or ‘levies’), e.g. demands for payment outside the usual demand dates provided for in the lease. This of course lessens the financial burden on landlords, RTM companies and RMC by allowing for additional funds to be raised in year, and minimises the need for year-end balancing charges. However, ad-hoc demands can only be issued where the lease allows and even then in strict accordance with the lease.

The balancing demand

The terms of the lease will dictate how the balancing demand should be issued and when it is payable. Some leases will specify methods of service, and in those cases many leases will provide that Section 196 of the Law of Property Act 1925 applies for service of demands.  Some leases will be silent as to how demands should be served.

As there can be delays in the year-end accounts being finalised and signed-off, landlords, RTM companies and RMCs must be mindful of the limitations imposed by Section 20B(1) of the Landlord and Tenant Act 1985 (“the 1985 Act”). The principle under Section 20B(1) is that a contractually valid demand must be issued to a leaseholder within 18 months of the charges subject to the demand being incurred. Where such a demand is not issued within that time, the charges are not payable. It is for this reason that, as a general rule of thumb, the balancing demand needs to be issued within 6 months of the relevant financial year-end.

The exception to this being where (instead of a demand) a notification is issued to the leaseholder within this 18 month period, notifying them of the charges incurred and that will be payable by them as a service charge. This is provided for under Section 20B(2) of the 1985 Act and then enables a demand to be issued outside of this 18 month period.

It is for this reason that landlords, RTM companies and RMCs should avoid treating the reserve fund as a ‘float’, to top-up the day to day service charge funds where there has been an over-spend or to credit it with any surpluses where there has been an underspend at the end of the financial year. Not only must the lease provide for any surpluses to be applied to the reserve fund, where funds have been collected for a reserve fund those funds must only be used for the specified purposes envisaged for a reserve fund in the lease. Additionally, this practice risks landlords, RTM companies and RMCs falling foul of Section 20B(1), if a valid demand has not been issued for the overspend (but instead been covered, unlawfully, by the reserve fund sums).

What to do if the leaseholder is in breach of the lease when the balancing charge is due?

Landlords, RTM companies and RMCs will rightly be advised not to issue any new service charge demands (including any balancing demands) to leaseholders who are in breach of the terms of their lease (for example, for non-payment of service charges), in order to preserve the landlord’s right to forfeit the lease for that breach. 

Section 20B(1) applies equally to leaseholders who are in breach and therefore the same rules for the issue of Section 20B(2) notices apply. Such a notice must be issued within the 18 month period of the charges being incurred (typically within 6 months of the year-end), to avoid the charges being time barred from recovery. Although that notice will need to advise the leaseholder that they will subsequently be required to contribute towards such costs by payment of a service charge, the notice will need to contain a caveat to the effect that the leaseholder’s lease is currently being treated as at an end, due to the current breach (e.g. arrears) and only once the breach has been remedied and the lease is treated as ongoing again, will they be issued with a demand and required to make payment.

For leaseholders who are in breach, landlords, RTM companies or RMCs (or, more likely, their agents) will therefore need to  make clear diary reminders to ensure that such Section 20B(2) notices are issued within 6 months of year-end in place of a demand, until such time as the breach has been remedied, to avoid any charges being later held to be irrecoverable. This applies not only to balancing charges (where the breach relates to all interim demands issued for the year), but also to all expenditure for the year (where demands have not been issued for some time due to an ongoing breach).

Other considerations

Another consideration for landlords, RTM companies and RMCs issuing balancing demands is the fact that, often, that demand will be under the £350 statutory threshold for forfeiture. Where that is the case, the landlord will have no right to forfeit the lease where that demand goes unpaid, even armed with a determination that the arrears are payable and even if the total arrears sum due from the leaseholder collectively exceeds the £350 threshold. This is because the statutory minimum £350 threshold for forfeiture applies to the last demand issued to the leaseholder, and not the collective balance.

In that event, where forfeiture is not an available remedy, other enforcement methods need to be explored to enforce a money judgment (in the case of arrears) and try to recover payment.

The other consequence of this is that, most commonly, leases will tie the leaseholder’s liability to pay legal costs for enforcement action either to proceedings under Section 146 of the Law of Property Act 1925 or the service of a notice under that provision, e.g. forfeiture action. The specific wording of that provision will control exact what costs are payable by the leaseholder, but if forfeiture is not available to the landlord then a costs provision like this is very likely to assist a landlord, RTM company or RMC to recover their costs of any enforcement action.

However, these issues are not ever lasting and often can be resolved at the point of the next service charge demand being due. Once a demand exceeding the statutory £350 threshold is issued and remains unpaid, a new right of forfeiture arises on that new demand at that point.

A consideration therefore when dealing with a balancing charge that is under the £350 threshold for forfeiture is whether to delay service of that demand and issue it with the next interim demand, where collectively those demands together exceed that threshold and a right of forfeiture is available. However, this can cause long delays if the demands are payable yearly for example, as opposed to half-yearly or quarterly, so may not be an attractive option in any event.

This is of course only an issue in those cases where leaseholders do not pay and there is a need for legal action to be taken, although it is not always clear that there will be an issue with payment until the demands go unpaid. For this reason, it is always advisable to deal with demands in such a way as to preserve the best possible enforcement options for the landlord, RTM company or RMC (which often means ensuring the landlord’s right of forfeiture will be available, if needed).  

The "Golden Rule"

The "Golden Rule" is (and has always been) ‘If in doubt - ask the lawyer first and only then act’.  

This approach ensures the best possible enforcement options are available and avoids potentially costly errors, ensuring that the correct procedure is carried out on behalf of all clients.  

Disclaimer

This Legal Update describes the position in law as at the date of this article and care should be taken to note any subsequent amendments to the position as set out above.  The Legal Update is provided free of charge for information purposes only; it does not constitute legal advice and should not be relied on as such. No responsibility for the accuracy and/or correctness of the information and commentary set out in the article, or for any consequences of relying on it, is assumed or accepted by any member of KDL Law or by KDL Law as a whole.

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